How the Foreign Tax Credit Saves Taxes for an S-corporation of a Limited Liability Company (LLC)
When you read about Apple or GE not paying American taxes, it is because of the foreign tax credit (for taxes they paid to the foreign government).
The purpose of the foreign tax credit law is to avoid double income taxation. It works well for publicly traded corporations. However, it does not work for individual owning a foreign entity unless he does fancy footwork to have the entity be a “pass-through” for the IRS.
Here is the problem: For the individual shareholder, income earned by a foreign corporation does not allow you credit for the foreign income taxes Why? No reason. It is just the law, and yes, it is not fair. Just keep reading for the solution.
If the corporation has paid an income tax, you are not allowed to offset your US tax. You will pay tax twice. First, the corporation will pay the foreign tax.
Next, you will pay US (and state) income tax on the Subpart F income or when the corporation invests in US property or when you receive a distribution (whichever event occurs first).
Here is the solution. Your foreign corporation needs to change to or elect to be a pass-through entity for U.S. tax law. Three type of pass-through entities exist. They “disregarded,” “partnership” and “Subchapter S corporation.” These topics are discussed in my book. However, first I would like to explain the issue with a hypothetical example.:
You own a foreign corporation doing business in the United Kingdom. The corporation’s net income in the tax year is $1,000. The UK income tax $250. Your corporation invests its profits in the US stock market. You have a “deemed dividend” of $750 taxable to the US. Your US tax is an additional $250. Thus, of the $1,000 earned, your worldwide tax is $500.
Once you are allowed the foreign tax credit, you use IRS Form 1116 or Form 1118 to claim your money.
Here is the best international tax strategy: The UK corporation becomes a “pass-through” entity for US tax purposes. Some, not all, foreign corporations can elect to be a “disregarded entity.”
A corporation that does not qualify for the election can arrange to have a charter as a domestic corporation. This is known as “dual resident corporation.” At this point, the corporation is both foreign (UK) and domestic. As a domestic corporation, the corporation can elect to be a Subchapter S corporation.
Back to the example, the $1,000 of income passes through to your individual income tax return. The $250 UK corporate income tax is a credit against your US income tax. You are U.S. taxable on $1,000. Assuming a US income tax of $300, your tax after the foreign tax credit is $50.
As a pass-through entity, none of the controlled foreign corporation rules applies.
Learn how the foreign tax credit works and how you can save money with my easy two-hour to read book, International Taxation in America for the Entrepreneur. Learn more on this link or call me, Brian Dooley, CPA, MBT, for a free foreign tax brainstorming consultation at 949-939-3414